Central Counterparty (CCP): Options Clearing Corporation $20 Million Fine: A Critique by Storm-7 Consulting – PART I (CFTC ORDER)
This four-part blog will provide an analysis of the $20 million fine imposed on The Options Clearing Corporation, and a critique of the Orders imposed by the United States Securities and Exchange Commission and the United States Commodity Futures Trading Commission. The first two parts of the blog will cover the Order made by the Commodity Futures Trading Commission which imposed a $5 million fine, and the second two parts of the blog will cover the order made by the Securities and Exchange Commission which imposed a $15 million fine.
About Options Clearing Corporation
“Founded in 1973, OCC is the largest clearing organization in the world for equity derivatives. Operating under the jurisdiction of the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodity Futures Trading Commission (CFTC), OCC issues and clears U.S.-listed options and futures on a number of underlying financial assets including common stocks and stock indexes. OCC’s clearing membership consists of approximately 100 of the largest U.S. broker-dealers, U.S. futures commission merchants and non-U.S. securities firms representing both professional traders and public customers. The stockholder exchanges share equal ownership of OCC. This ownership, along with a significant clearing member and public director presence on the Board of Directors, ensures a continuing commitment to servicing the needs of OCC’s participant exchanges, clearing members and their customers. OCC provides clearing services for options, financial and commodity futures, security futures, securities lending transactions and over-the-counter index options.”
On 4th September 2019 the United States (US) Securities and Exchange Commission (SEC) and the US Commodity Futures Trading Commission (CFTC) announced that The Options Clearing Corporation (OCC) would be undertaking remedial efforts, and that they had agreed to pay $20 million in penalties in lieu of settlement of charges that it had failed to implement policies to manage certain risks as required by US laws and SEC and CFTC rules.
Proceedings Before the CFTC
As a Derivatives Clearing Organization (DCO), OCC is required to comply with the DCO Core Principles (Core Principles) which establish standards for the operation of DCOs.[i] In the CFTC Order, the CFTC noted that the Core Principles impose inter alia, requirements relating to:
(1) the financial, operational, and managerial resources of a DCO;
(2) risk management standards;
(3) rules and procedures relating to management of clearing member defaults;
(4) risk analysis and oversight of operations and automated systems; and
(5) clearinghouse governance standards.
The CFTC found that OCC had failed to fully comply with specified Core Principles by failing to establish, implement, and enforce certain policies and procedures reasonably designed to:
(1) consider and produce margin levels commensurate with every potential risk and particular attribute of each relevant product cleared by OCC; and
(2) effectively measure, monitor, and manage its credit exposure and liquidity risk; and
(3) protect the security of certain of its information systems.
The CFTC Order observed that:
“DCOs are an essential part of the U.S. futures and options markets and, as such, they are required to be structured to manage and reduce risk. In instances where a DCO is not structured and operated appropriately, it can pose a risk to the broader financial system. Disruption to OCC’s operations, or failure by OCC to manage risk, could result in significant costs not only to OCC itself and its members, but also to other market participants.”
Material Representations by OCC
In its 2017 Annual Report entitled “Innovate, Educate, Advocate” (as of 31st December 2017), OCC expressly stated in Note 17. Contingencies, at page 47:
“In the normal course of business, OCC may be subject to various lawsuits and claims. In addition, as a regulated entity, OCC is subject to examinations by the SEC and CFTC. From time to time, such examinations result in regulatory findings or other matters, the resolution of which could in the future include remediation or fines. At December 31, 2017, there was no outstanding litigation or regulatory matters that would have a material adverse effect on the financial statements.”
In its 2018 Annual Report entitled “Clear the Path” (as of 31st December 2018), OCC expressly stated in Note 17. Contingencies, at page 46:
“In the normal course of business, OCC may be subject to various lawsuits, claims, and other legal proceedings. In addition, as a regulated entity, OCC is subject to examination by the SEC and CFTC. In connection with these regulatory and legal matters, OCC has accrued $15 million as of December 31, 2018. Actual settlement amounts may exceed amounts accrued and such amounts could be material.”
Failure to Comply with Core Principles B, D, and I
The CFTC Order found that OCC had failed to comply with Core Principles B, D, and I.
The CFTC Order found that OCC had failed to establish, implement, maintain, and enforce policies and procedures reasonably designed to:
(1) REQUIRE REVIEW OF ITS RISK-BASED MARGIN MODELS AND THE PARAMETERS FOR THOSE MODELS ON A REGULAR BASIS;
Core Principle D requires a DCO to ensure that it possesses the ability to manage the risks associated with discharging the responsibilities of the DCO through the use of appropriate tools and procedures.[ii]
A DCO is also required to use margin requirements to cover its potential credit exposures to clearing members, and that each model and parameter used in setting such margin requirements be risk-based and reviewed on a regular basis.[iii]
It was found that OCC failed to fully establish, implement, maintain, and enforce policies and procedures reasonably designed to require review of its risk-based margin models and the parameters for those models on a regular basis.
In February 2018 a spike in a barometer of market sentiment in the US, namely the CBOE Volatility Index (or VIX), spiked in early February, thereby causing a huge cascade of issues in the options market, leaving many traders with significant market losses.
Subsequent to this event, the SEC and CFTC launched probes into OCC’s risk management models and margin rules to identify whether the clearinghouse for the US options market had failed to accurately anticipate how much liquidity would be needed to cover the losses, i.e. whether there were any rule violations in relation to the calculation of margin levels, stress testing of positions, and maintaining critical computer systems. It is these initial investigations, combined with earlier investigations that culminated in this final review by the CFTC.
A CCP’s margin models are an absolutely fundamental part of its ongoing operations. From an operational perspective, if a CCP’s margin models are not accurate then clearing members (indirect, direct) will be posting too much, or too little margin, depending on the calibration of the margin model. If clearing members post too much margin, then the costs of trading increase and this can hamper market trading and, in turn, market liquidity, thereby affecting market volatility. If clearing members post too little margin, then in the event of adverse market events, and potential defaults of clearing members, the CCP will not hold sufficient margin to cover any potential default scenario and will then have to revert back to using its other default defences as delineated in its default waterfall.
The main points to note here are that the OCC was founded in 1973. In 2001 it was registered with the Commission as a DCO for the clearing of futures contracts and options on futures contracts, and since 2008, it was further authorized to clear commodity options executed on a designated contract market, in addition to futures contracts and options on futures contracts. It therefore had decades of operational experience under its belt.
It is the largest clearing organization in the world for equity derivatives. Moreover, it has been designated as a ‘Systemically Important Financial Market Utility’ (SIFMU)[iv], and therefore it was not only required to set the bar in terms of world class standards, but it was also supposed to lead by example by showcasing best practices globally. Yet, according to the CFTC Order, the OCC had failed an objective test which modestly set the bar at “reasonably designed”, i.e. the policies and procedures to review its risk-based margin models and the parameters for those models on a regular basis were alleged to be not even reasonably designed.
Viewed in such terms, if the allegations were proved to be correct, the OCC would have done an abysmally terrible job at living up to such standards, especially since margin methodologies are one of the most crucial operational aspects of any functional CCP.
(2) CONSIDER AND PRODUCE MARGIN LEVELS COMMENSURATE WITH THE RISKS AND ATTRIBUTES OF EACH RELEVANT PRODUCT CLEARED BY OCC;
A DCO is required to establish Initial Margin (IM) requirements that are commensurate with the risks of each product and portfolio, including any unusual characteristics of, or risk associated with, particular products or portfolios, including but not limited to jump-to-default risk or similar jump risk.[v]
The Order noted: “To date, OCC has not fully established, implemented, maintained, or enforced policies and procedures reasonably designed to consider and produce margin levels commensurate with every potential risk and particular attribute of each relevant product and portfolio cleared by OCC. OCC’s margin model fails to fully consider the impact of market liquidation costs, including bid-ask spreads and other transaction-based costs, as well as the potential market impact of liquidation activity.
There are two main aspects relating to this finding. The first is that the top priority for any CCP in operation today, is developing and calculating in a highly accurate way, and recalibrating on a regular basis, what is referred to as ‘the margin period of risk’ (MPOR).
The MPOR is defined as “the term used to refer to the effective time between a counterparty ceasing to post margin and when all the underlying trades have been successfully closed out and replaced (or otherwise hedged)” (Gregory, 2014).[vi] The more accurate the calculation of the MPOR, the more accurate the margin model reflects the margins required to accurately and efficiently deal with a clearing member default. The MPOR combines two periods, namely:
(1) ‘pre-default’, which represents the time before the counterparty defaults and includes the contractual period for making margin calls (e.g. daily), and operational delays in requesting and receiving margin; margin disputes; settlement of non-cash margin; grace period given from a party failing to post margin to being deemed to be in default; and
(2) ‘post-default’, which includes the time to close out trades; re-hedging and/or replacement of positions; and auction of trades (Gregory, 2014).
The MPOR will differ depending on the particular type of financial instrument being cleared in question. However, what can be said is that generally speaking derivatives that are traded on an exchange (i.e. Exchange Traded Derivatives (ETD)) are more standardised than over-the-counter (OTC) derivatives that are subsequently cleared on a CCP. Therefore, the market liquidation costs, bid-ask spreads and other transaction-based costs, as well as the potential market impact of liquidation activity, are easier to calculate for ETD than they are for OTC derivatives cleared on a CCP.
If current CCPs such as Eurex Exchange operating in Germany have developed highly accurate and comprehensive margin models to fully consider the impact of market liquidation costs, bid-ask spreads, and other transaction-based costs, as well as the potential market impact of liquidation activity for OTC cleared derivatives, it is difficult to see why OCC has failed to do so for ETD.
Now, it is at this point that matters become really interesting. In September 2013, following two-and-a-half years of examinations by federal market authorities, regulators levelled a wide-ranging critique of the way OCC managed risk and handled compliance. This included criticisms of the way OCC measured financial risks facing its members, flaws in the way that OCC prepared for market freeze-ups, senior management supervision failures by the OCC’s Board, and improper management of conflicts of interest. A letter sent to OCC dated 8thSeptember 2013 by the SEC stated that:
“[The] excessive number of repeat findings raises a serious concern about OCC’s overall commitment to establishing a culture of regulatory compliance and, more specifically, its ability to timely and adequately address the Staff’s findings.”
At the time, Jim Binder, spokesman for OCC enunciated that:
“We are diligently working on a response that will confirm our commitment to resolving the issues identified in the letter, and that will describe the processes that we’ve put in place over the last year or so to prevent a recurrence of similar shortcomings in the future.”
Jim Binder noted that the OCC was taking the SEC examination letter “very seriously”. In fact, it was taken so seriously that more than five years later the OCC was hit with a $20 million fine for pretty much the same failures identified previously.
[TO BE CONTINUED]
[i] As a condition of registration under Section 5b of the Commodity Exchange Act (CEA), 7 U.S.C. § 7a-1 (2012), and implementing provisions set forth in Part 39 of the Commission’s Regulations (Regulations), 17 C.F.R. pt. 39 (2019).
[ii] Section 5b(c)(2)(D)(i) of the Act.
[iii] Regulation 39.13(f) and (g)(1).
[iv] Under Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).
[v] Regulation 39.13(g)(2)(i).
[vi] Gregory, J. (2014). Central Counterparties. Mandatory Clearing and Bilateral Margin Requirements for OTC Derivatives. John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex.